The gold rush continues

As San Francisco and the rest of the Bay area continue to lure dot.coms, the region's real estate market reaches new heights.

Ask for information about real estate markets in the San Francisco Bay Area today and you're very likely to get answers like "white hot," "red hot" or just plain "hot." It doesn't matter which category you're asking about - office, industrial, retail or multifamily - the answer almost always comes out as a variant of the above.

With good reason. As ground zero in the communications revolution, the Bay area is not just thriving but booming, and booming in a manner never quite seen before. Unlike the speculative boom of the 1980s, there is little overbuilding, high-risk lending or charging forward on a wing and a prayer.

In the words of Allen Palmer, senior vice president of marketing for San Mateo, Calif-based Legacy Partners, "It's a very balanced market." What's more, he adds, it looks as if it's going to stay that way for the foreseeable future. "I think we've still got legs in this economy," he says. "Our market cycle has a way to go."

But if it's balanced, it's balanced at a very great height. This teeter-totter is not 18 inches off the ground but 18 stories. The market has reached these giddy new heights, thanks largely to the visionaries who, 30 years ago, made the jump from typewriter to computer keyboard, and more recently recognized the leap from reality to virtual reality as the key to the future.

Nothing reflects the current boom more strikingly than the San Francisco office rental market. According to Bethesda, Md.-based CoStar Group International Inc., the City by the Bay has the highest average Class-A office rental rate in the nation at $78.29 per sq. ft. per year, topping second-place Manhattan's $67 per sq. ft. average by more than 15%. The rate continues to rise, with a growing number of leases coming in over $100 per sq. ft.

Even more remarkable is that at least one submarket tops San Francisco. An invasion of venture capitalists has driven rents around Stanford Research Park in Palo Alto through the roof, with the average rent approaching the three-digit mark and rents topping out above $140 per sq. ft.

Record rents Downtown San Francisco is not the only area experiencing record rents. Virtually every Bay Area submarket is doing likewise. For example, according to Los Angeles, Calif.-based CB Richard Ellis, rents on the San Francisco Peninsula have gone up for six straight quarters, with monthly Class-A rates at an astounding $8.50 per sq. ft. and Class-B at $7.36 per sq. ft. The brokerage reports a stratospheric $12 per sq. ft. for the Menlo Park/Palo Alto submarket.

Even downtown San Jose and downtown Oakland, both of which have struggled gamely for several decades to earn a little respect, are experiencing rapid turnarounds. According to Mark Ritchie, president of Ritchie Commercial Real Estate in San Jose, the downtown San Jose office market is setting "new high-water marks for Class-A space," with some monthly rates hitting $5.50 per sq. ft. to $6 per sq. ft.

Based on statistics from CB Richard Ellis, Class-A rates in downtown Oakland are approximately $4.50 per sq. ft. to $5 per sq. ft., up from approximately $3 per sq. ft. a year ago. Vacancies in both markets are under 2%.

The low vacancies and climbing rents also have sparked new development in those markets. San Francisco-based Shorenstein Co. L.P. recently broke ground on downtown Oakland's first private-market office building in a decade, the 472,000 sq. ft. 555 City Center, while no less than three new office towers are under construction or in the planning stages in downtown San Jose.

The reason for the turnaround, says Ritchie, is not simply a matter of low vacancies in surrounding markets forcing tenants to consider locations they previously would have rejected. It is also a matter of meeting the tastes of a new generation of employees.

"There is a compactness and synergy [downtown] that is attractive to technology companies," explains Steve Botto, a vice president at Ritchie. "What I'm hearing from a growing number of tenants is that they're not able to attract the people they need to build their business unless they're in the heart of things. Their employees don't want to be in East Hopscotch."

Brokers in "East Hopscotch" don't fully agree because a large number of Internet-related companies also have chosen to locate in more outlying areas. PeopleSoft Corp., Groundswell and Greenlight all are headquartered in the Tri-Valley area of southern Alameda County, and Sybase Corp. just broke ground on a new headquarters campus there.

Sales prices, not surprisingly, are right up there with rents. Several recent San Francisco office sales came in over $400 per sq. ft., and 223 Fremont Street sold for a remarkable $470 per sq. ft. Virtually every other submarket also reported record deals. For example, San Mateo Plaza, an eight-story, 135,085 sq. ft. office building in San Mateo recently sold for $49 million, or $370 per sq. ft. That is the highest rate ever paid on the Peninsula, according to Gary Willard of CB Richard Ellis. However, he notes that there are at least two Peninsula properties for sale with asking prices of more than $425 per sq. ft.

Amazingly, prices seem not to have peaked. Willard says he expects prices to rise at least 10% throughout the Bay area by the end of this year. That estimate, he adds, is conservative. He and others anticipate prices soon reaching $500 per sq. ft. in San Francisco.

One of the big questions in the investment market concerns the value of dot.com tenancies. Internet-related businesses make up a significant portion of the tenant market today, but their lack of a track record makes some investors uneasy. Despite glorious beginnings, several prominent dot.coms already have gone under, so buyers can't help but wonder whether a 10-year lease with "whosit.com" means anything.

Legacy's Palmer says his company got one resounding answer in the affirmative, though not from the investment market as anticipated. Inktomi Corp., which last year signed a 10-year lease for 177,000 sq. ft. in Legacy's 262,000 sq. ft. Bayside Towers complex in Foster City, worked out an agreement to buy the property through a synthetic lease.

Although a fair number of tech companies have used this approach to develop corporate campuses, to Palmer's knowledge, this is the first time it has been used to buy an existing project originally built on spec. Furthermore, he reports Legacy has several other similar deals in progress.

Although this approach could provide a great exit strategy for some landlords with large, successful dot.com tenants, it doesn't indicate how investors view the situation. This year's only office building sales in San Francisco's South-of-Market district, the very heart of the multimedia and Internet revolution, suggest buyers are very cautious.

Where Class-A buildings in the city's traditional Financial District now routinely sell at prices in the $400 per sq. ft. range, two Class-A buildings south of Market Street leased almost entirely to dot.com tenants sold for an estimated $300 per sq. ft. each. This is despite the fact that rents in both areas are equal.

Not all submarkets are equally expensive. 1333 Broadway, a 10-story, 238,000 sq. ft. office building in downtown Oakland, recently sold for $31.75 million, or $133 per sq. ft. According to Mark Krol, a broker with CB Richard Ellis, the buyers got an exceptionally good deal.

Sizzlin' Sacramento San Francisco's neighbor to the east, Sacramento, also boasts a sunny real estate climate. According to Los Angeles-based CB Richard Ellis, economic conditions in the Sacramento area remained strong during the second quarter, with unemployment dropping to 3.7%, the lowest level in 50 years.

The office market remained healthy in the first half of the year, with construction activity increasing. CB Richard Ellis reports that the overall vacancy rate was 7.13% in the second quarter, a slight decrease from the previous quarter, and eight buildings totaling 525,000 sq. ft. were introduced into the market. Another 1.4 million sq. ft. of office space was under construction at the end of the second quarter. One of the city's biggest office projects in recent years was the $65 million Esquire Plaza, which also includes a restaurant and IMAX theater. Completed in 1999, the building was developed by San Diego-based Lankford & Associates.

According to CB Richard Ellis, the Sacramento retail market sizzled in the second quarter. More than 2.4 million sq. ft. of space was under construction, and at least 31 major retail projects totaling 4.7 million sq. ft. were in the planning stages or under construction.

The industrial market also remained strong during the first half of 2000, especially along the Interstate-80 and Interstate-5 corridors. More than 800,000 sq. ft. of new construction was completed in the entire region during the second quarter, and 45 industrial buildings were under construction. These buildings will bring more than 4.6 million sq. ft. into the market in the next six to 12 months, and vacancy rates are expected to remain healthy, in the 5% to 7% range.

Evolving industrial market In terms of conventional industrial uses, the majority of new manufacturing and distribution development has been shunted to a few submarkets: Hayward-Union City, Richmond, Livermore, Concord and Sonoma County. But that hardly means the existing markets have disappeared. Oakland still has about 33 million sq. ft. of industrial product, while San Jose, the heart of Silicon Valley, has even more.

But as with offices, vacancies are very low. Even in Hayward-Union City, the largest industrial submarket on the east side of San Francisco Bay with some 57 million sq. ft. of product, the vacancy rate was 3.3% in June, down more than two points since January.

"The market's much more competitive than in the past," asserts Greig Lagomarsino, a senior vice president in the Oakland office of New York-based Colliers International. He mentions a typical scenario of three and four tenants bidding on any space that becomes available in the submarket, explaining the competition is being driven by companies seeking to escape the high rents of the Peninsula and Silicon Valley. Where Hayward and Union City start at about 45 cents per sq. ft., markets on the west side of the bay start at $1 per sq. ft.

In many submarkets, industrial product is being converted to high-tech uses. Fremont, once a hub of manufacturing, has become an extension of Silicon Valley, with existing projects rapidly converting to research-and-development use due to starting rents of 80 cents per sq. ft., according to Lagomarsino. In San Francisco, approximately half the industrial and service space left in the city in 1990 has been converted to multimedia and Internet use or loft-style residences, and the conversions have not stopped.

The conversion phenomenon is spurred not only by a shortage of office space but also by a desire from today's technology and Internet firms for "funky" space that goes against the button-down ideals of traditional business. This summer, the San Francisco-based Martin Group acquired a Nabisco Inc. distribution center in Brisbane for conversion to office space for dot.com and related companies. According to Michael Prudhomme, a vice president in the San Francisco office of Colliers, the redesign will retain as much of the building's industrial character as possible.

A good indicator of the west sub-market's push to high-tech use is the estimated $140 per sq. ft. Martin paid for the Nabisco property. An even better indicator is Xilinx Inc.'s purchase of 200,000 sq. ft. of flex space in San Jose for $340 per sq. ft.

Retail redevelopment Although the Bay area's wealth makes it a prime target for retailers, the region has been characterized by an imbalance between demand and development for at least a decade. As a result, the area is dramatically "understored," at least in the opinion of most retail analysts.

There are very few new sites available for development, and most of those are at the outermost edges of the region. And even some of these are available more in theory than fact due to continuing conflicts over preservation of open space and agricultural land. In August, for example, the Contra Costa Board of Supervisors modified urban limit lines to exclude 14,000 acres that had previously been earmarked for development.

Consequently, developers have little choice but to redevelop or convert existing sites. The three largest retail projects currently under development all entail reuse of existing sites. Furthest along is Santana Row, a project by Rockville, Md.-based Federal Realty Investment Trust, at the site of a former San Jose strip shopping center. Currently under construction, the project will mix 680,000 sq. ft. of retail with 1,200 residential units.

Madison-Marquette, Cincinnati, is preparing to begin construction on a large mixed-use project with 400,000 sq. ft. of retail on a rezoned industrial site in Emeryville. Cleveland-based Forest City Development is seeking approvals for a 1.4 million sq. ft. mixed-use project in San Francisco built in the shell of the shuttered Emporium department store. All three projects also include hotels.

Fortunately, the area's high rents make the costly and time-consuming redevelopment process worthwhile for owners and developers. On San Francisco's Union Square, annual rents above $300 per sq. ft. have been standard for several years, but now local brokers report landlords have been asking $150 per sq. ft. for spaces off the square that rented for $50 per sq. ft. as recently as 1998.

Rents are rising dramatically outside the city as well. According to Craig Semmelmeyer, a principal of Main Street Retail Advisors in Lafayette, Calif., Tiffany & Co. signed a lease for 9,000 sq. ft. in downtown Walnut Creek at $5.40 per sq. ft. per month, the highest retail rent ever recorded in Northern California outside San Francisco. Vacancy rates under 5% in almost all major submarkets and as low as 2% in some markets account for the steep rents, according to reports from CB Richard Ellis.

Of course, steep prices also are the norm. As in other categories, retail properties are selling for record rates. According to Timothy Rosten, a former vice president in the Oakland office of CB Richard Ellis, the owner of a fully leased, 15-year-old center anchored by a supermarket in San Leandro is asking $172 per sq. ft. for the property on a cap rate of 8.9%.

The living isn't cheap According to the California Association of Realtors (CAR), Bay area home prices rose 8% to 29% in the last year, depending on the submarket. A recent report to the San Francisco Board of Supervisors indicated only 18% of local households can afford a median-priced home, which now exceeds $500,000, including both single-family homes and condominiums, according to CAR.

The same competition for space that has driven home prices to record levels has driven up apartment rents as well. Palo Alto, Calif.-based Marcus & Millichap Commercial Real Estate Investment Brokerage Co. ranks San Francisco, San Jose and Oakland the second, third and sixth most expensive apartment markets in the nation, respectively.

A recent report from the San Francisco Association of Realtors reveals the average rent for a two-bedroom apartment in San Francisco is $1,900 a month, and rising. Rents in Marin, San Mateo and Santa Clara counties are at equivalent levels. Other markets are less expensive, but finding a two-bedroom apartment under $1,000 per month is nearly impossible throughout the Bay Area.

Research from the Association of Bay Area Governments (ABAG) indicates need far outstrips production of both for-sale and rental units. The U.S. Bureau of the Census reports Bay Area developers pulled permits for 302 multifamily projects with a total of 5,349 units in the first seven months of 2000. ABAG estimates a need for at least twice that number of units.

Statistics such as these obviously lay the groundwork for a strong investment market. Since the nine-county Bay area population is projected to grow from 6.9 million in 2000 to 8 million in 2020, the market will only get stronger. According to Larrie Furst, director of investment sales at TRI Cold-well Banker in San Francisco, owners are holding on to their properties because they are enjoying good returns. Legacy's Palmer notes local jurisdictions are aggressively promoting high-density, mixed-use projects that combine multifamily residential with office or retail uses.

Hotels in demand L.R. Waterman, associate vice president of Colliers International Hotel Realty in San Francisco, uses the ubiquitous term "white hot" to describe the region's hotel market. "The demand for hotels is tremendous," he says.

According to Anwar Elgonemy, an associate with San Francisco-based PKF Consulting, the region's occupancy levels rose 7% from January through June. He says the average daily room rate (ADR) went up 8.5 % in the same period.

San Francisco proper has posted even more dramatic results, making it one of the strongest hotel markets in the United States right now, he adds.

By PKF's calculations, the city's ADR has risen 10.3% to a current level of $161 per night, putting it second only to Manhattan. Meanwhile, occupancy has increased from 78% for in 1999 to 84% for the first eight months of 2000.

A confluence of factors has produced the happy results, the two analysts point out. To begin with, the strong U.S. economy has given people the opportunity to travel more often and for longer periods.

As one of the most popular tourist destinations in the world, the San Francisco area benefits greatly from this trend. In addition, notes Elgonemy, both San Francisco and San Jose are enjoying banner convention years. Convention business has been so strong, in fact, that San Francisco has a half-block underground extension of Moscone Convention Center under construction, while San Jose will decide shortly whether to move ahead with an expansion that would nearly double the size of the McEnery Convention Center.

According to PKF, despite nine straight years of increasing occupancy levels, San Francisco's inventory of rooms increased only 6.5% between 1991 and 1999, an addition of 1,900 rooms.

However, more than 1,000 rooms are under construction and slated to open between now and 2002. That includes the 108-room Orchard Hotel and 253-room Holiday Inn Express slated to open later this year, the 400-room Four Seasons and 414-room Courtyard by Marriott scheduled to open next year, and the 360-room Omni slated for a 2002 opening.

Other projects are in the pipeline. Two large convention hotels are under development in San Jose, and several smaller full-service hotels are planned at various commercial hubs throughout the region. For example, San Francisco's Kimptom Hotel Group plans a 224-room facility as part of Cupertino City Center.

Despite the new projects, Waterman and Elgonemy say there is room for more. Neither analyst believes overdevelopment will occur due to the high barriers to entry, particularly in San Francisco and on the Peninsula. Barriers include competition for capital and space, a demanding regulatory environment and extremely high construction costs.

Elgonemy gives the region very high ratings in terms of potential returns, but adds that few properties are on the market because owners are enjoying their profits rather than selling. However, Waterman reports Colliers is marketing several hotels near San Francisco International Airport, all of which are for sale because their owners are looking to concentrate on the luxury market.

According to Elgonemy, when sellers do decide to sell, they expect a top price. He reports San Francisco's Westin St. Francis sold in April for $243 million, or $204,000 a key, while the Westin Santa Clara sold in December for $110 million, or $218,000 a key. Buyers are reluctant to pay these rates, he adds, because the combination of high price and today's higher interest rates makes it difficult to clear a profit.